Vanguard CIO: Beware ETF Proliferation

By Brendan Conway

The chief investment officer of Vanguard Group is arguing the fund industry does financial advisers and their investors a disservice: Overwhelming them with a blast of new ETFs.

“I think it’s fair to say that advisors feel pressure from the fund industry, and if not pressure, then at least a lot of noise,” Vanguard CIO Tim Buckley told attendees of the annual Inside ETFs conference in Florida on Monday morning. “Our industry does you a disservice with the proliferation of product. You should feel overwhelmed, having to comb through some 700 ETFs that have been launched since 2010.”

It’s not a new line from Vanguard, which is the stingiest of the big ETF providers in building new funds. But the stridency of the message appears to be picking up a bit. Notably, Buckley took aim at what is arguably the hottest area for new ETF launches: So-called “smart beta” funds, which slice stock-market exposure according to a range of factors, such as earnings, dividends, profit margins and so forth.

“Product proliferation cloaks itself as innovation and often mirrors cyclical trends and success in the broader market,” Buckley said. “You’ll hear a lot about [smart beta] in the next few days.”

Buckley’s objection is less about the strategies per se than about the manner in which they transform indexing into a mechanized form of active management – one whose performance is likely to turn around once the “factors” switch into reverse gear.

“It’s largely a factor-based strategy that, more often than not, combined two successful factors, value and size. It is not news to anyone that smaller (mid-cap) value has outperformed larger growth in the 10 years ended 2013.

Over the same time frame, Buckley noted, the pendulum of fund flows swung heavily in the direction of these investing styles. The data he cited: In 2000, for every $100 invested in mid-cap growth funds, there was $7 in mid-cap value. Currently, it’s $100 to $60, a nearly ninefold rise.

Buckley also had a caution on back-tested ETF strategies, noting how often they boast of great historical (hypothetical) performance, only to post below-average returns when they go live. The data on that subject: Vanguard’s study of backtested ETF strategies found the group posted annualized 10.31% ecess performance versus the index, only to lag by 0.93% after launch.

“The ‘caveat emptor’ here is that strong back-tested results may have little or no persistence going forward,” Buckley said.

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